DETERMINANTS OF DEBT CAPACITY 1st set of transparencies for ToCF - PowerPoint PPT Presentation

Slide1 l.jpg
Download
1 / 38

  • 268 Views
  • Uploaded on
  • Presentation posted in: General

DETERMINANTS OF DEBT CAPACITY 1st set of transparencies for ToCF. INTRODUCTION. INTRODUCTION. I. I. Adam Smith (1776) - Berle-Means (1932). Agency problem. Principal. outsiders/investors/lenders. Agent. insiders/managers/entrepreneur. 1. Insufficient ‘‘effort’’

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

Download Presentation

DETERMINANTS OF DEBT CAPACITY 1st set of transparencies for ToCF

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


Slide1 l.jpg

DETERMINANTS OF DEBT CAPACITY

1st set of transparencies for ToCF


Slide2 l.jpg

INTRODUCTION

INTRODUCTION

I.

I.

Adam Smith (1776) - Berle-Means (1932)

Agency problem

Principal

outsiders/investors/lenders

Agent

insiders/managers/entrepreneur

1. Insufficient ‘‘effort’’

2. Inefficient investment

3. Entrenchment strategies

4. Private benefits

Good governance:(1) selects most able managers

(2) makes them accountable to investors

2. Inefficient investment

Pet projects.

Empire building.


Slide3 l.jpg

OUTLINE

Approach: controlled experiment

Topics:

  • 1. Micro

  • Basics:(a)one-stage financing: fixed and variable investment models;

  • (b)applications: debt overhang, diversification, collateral pledging, redeployability of assets.

  • Multistage financing: liquidity ratios, soft budget constraint, free cash flow.

  • Financing under asymmetric information.

  • Exit and voice in corporate governance.

  • Control rights.


Slide4 l.jpg

  • 2. Macro

  • Dual role of assets and multiple equilibria.

  • Credit crunch.

  • Liquidity shortages.

  • Liquidity premia and pricing of assets.

  • Political economy of corporate finance.


Slide5 l.jpg

II.

BASICS OF CREDIT RATIONING: FIXED INVESTMENT MODEL

Lenders / investors /outsiders

Project costs I.

Has cash A < I.

Entrepreneur / borrower / insider

Key question: Can lenders recoup their investment?


Slide6 l.jpg

TYPICAL MODEL

• Risk neutral entrepreneur has one project, needs outside financing.


Slide7 l.jpg

Want to induce good behavior:

and

Contract: Success:

Rb + R =R.

Failure: 0 each (optimal).


Slide8 l.jpg

Reward Rb in case of success

Necessary and sufficient condition for financing

or

PLEDGEABLE INCOME  INVESTORS’ OUTLAY

Minimum equity:


Slide9 l.jpg

Remarks

(1) Entrepreneur receives NPV

Will always be the case with competitive financial market.

(2) Reputational capital / scope for diversion (shortcut)

A increases with B.

Note : Courts can help reduce B

(3) Investors’ claim: debt or equity?

(At least) two interpretations:

  • inside equity + outside debt (R to be reimbursed);

  • all-equity firm: shares

No longer true if leftover value in case of failure. In any case: no need for multiple outside claims.

weakness,

strength (focus on fundamentals).


Slide10 l.jpg

DEBT OVERHANG

Definition:(project would always be financed inabsence of previous claim).

Example:

A < 0new investment cannot be financedsolely because renegotiation with initialinvestors infeasible.

Previous claim is senior.

Borrower no longer has cash (A =0).


Slide11 l.jpg

a) Bargaining with initial investors, who have cash

Noone receives anything if no investment.

Investment: Choose Rbsuch that

and

Feasible since

b)Initial investors don’t have funds to invest. Bargainingwith new investors only.

Income that can be pledged to new investors:

by assumption.

cannot raise funds.

DEBT OVERHANG


Slide12 l.jpg

c)Initial investors don’t have funds to invest. Bargainingwith new and initial investors.

Debt forgiveness: where

That is

When is debt overhang an issue?

– Many creditors. Examples:

  • corporate bonds

  • (nomination of bond trustee, exchange offers)

  • interbank market/derivatives/guarantees,..

– Asymmetric information (not in this model).


Slide13 l.jpg

III.

BASICS OF CREDIT RATIONING/VARIABLE INVESTMENT MODEL

1. EQUITY MULTIPLIER / DEBT CAPACITY

Implicit (perfect) correlation hypothesis: specialization,voluntary correlation, macro shocks.


Slide14 l.jpg

Notation:

income per unit of investment

pledgeable income per unit of investment

Assumption

First inequality: finite investment

Second inequality: positive NPV (otherwise no investment).

Constraints:

and

Borrower’s utility (=NPV)

wants to maximize I.


Slide15 l.jpg

DEBT CAPACITY

Utility


Slide16 l.jpg

DEBT OR EQUITY? THE MAXIMAL INCENTIVE PRINCIPLE

Extension: RSI in case of success

RFI in case of failure (salvagevalue of assets)

Generalization of


Slide17 l.jpg

Optimal sharing rule:

s.t.

and

Breakeven constraint binding (otherwise ).

wants to maximize I.


Slide18 l.jpg

Incentive constraint binding (otherwise debt capacity)

Suppose Then

relaxes incentive constraint.

Outside debt maximizes inside incentives

Generalization: Innes (1990).

Discussion:

  • risk taking,

  • broader notion of insiders,

  • risk aversion.


Slide19 l.jpg

2. DIVERSIFICATION

Diamond (1984)’s diversification argument.

n projects.

IRS due to the possibility of cross-pledging.

Basic idea:


Slide20 l.jpg

TWO IDENTICAL PROJECTS

Rewards R0 , R1 , R2

Risk neutrality R0 = R1 =0.

Other IC constraint is then satisfied


Slide21 l.jpg

Nonpledgeable income

Financing condition. Entrepreneur’s equity= 2A.

PROJECT FINANCE IS NOT OPTIMAL


Slide22 l.jpg

Continuum of independent projects

Two cases: pHR - B - I < 0 : net worth still plays a role

pHR - B - I > 0 : unlimited size

Second case: continuum of projects, mass 1.

Debt contract: D=I

Work on all: pHR - D = pHR- I > 0

Work on y % of the projects:

either y pH R + (1-y) pLR < I then y=0 better, but dominated

or y pH R + (1-y) pLR  I

payoff increases with y ((p )R > B)


Slide23 l.jpg

LIMITS TO DIVERSIFICATION

• limited attention,

• core competency,

• endogenous correlation (asset substitution, VaR)

continuum:


Slide24 l.jpg

3. LIQUIDITY NEEDS

In case of "liquidity shock", rbinvested yields : rb> rbto

entrepreneur (none of which is pledgeable to investors).


Slide25 l.jpg

Two issues:

• imperfect performance measurement at date 1

• strategic exit (if liquidity shock unobservable, 2 dimensions of MH: effort, truthful announcement of liquidity need).

Contract (can show: no loss of generality)

Menu:

• Rbin case of success at date 2, or

• rbat date 1.


Slide26 l.jpg

Benchmark: Liquidity shock observable

or

Independent of rb!

Pledgeable income (for given rb) :

Must exceed I-A  rbcannot be too large!


Slide27 l.jpg

Case 2: Possibility of strategic exit

Assume pL=0 (or, more generally, small)  wants to exit if shirks.

or

pL = 0  (2) is more constraining than (1).

Must also have

Pledgeable income: (for given rb)


Slide28 l.jpg

when rb >0. And:

Lower pledgeable income, same NPV. *

* for a given rb. But rbis smaller!


Slide29 l.jpg

Benefit from speculative monitoring at date 1.

Signal: good or bad. Good signal has probability qHor qL.

Incentive constraint:

Disciplines entrepreneur.

  • Same if active monitor as well.

  • In practice

  • – sale to a buyer,

  • – IPO.

VC exit is carefully planned.

  • Reversed pecking-order logic: want risky claim to encourage speculative monitoring.


Slide30 l.jpg

4. COLLATERAL / REDEPLOYABILITY OF ASSETS

  • Pledging collateral:–increases pledgeable income,

  • – boosts incentives if state-contingent pledges.

  • Cost of collateralization:– transaction cost,

    – suboptimal maintenance,

    – lower value for lender.

  • Redeployability of assets boosts debt capacity

Proper credit analysis:

relevant value of collateral  average value:

– low maintenance near distress,

– aggregate shocks.


Slide31 l.jpg

Assumption: 0  P 1

Previously: x = 1.

  • Positive NPV:

  • Breakeven condition:

I grows with P.

(grows with P, for two reasons).


Slide32 l.jpg

5. ENDOGENEIZATION OF P: SHLEIFER-VISHNY (1992)

(chapter 14 in book)

Idea : P endogenous, depends on existence of other firms able to purchase asset.

Model : 2 firms in industry (do not compete on product market). "Local liquidity": only other firm can buy asset.

Entrepreneur i : cash Ai, borrows Ii -Ai.

If j in distress and i not in distress, i (with the help of lender i) can buy j’s assets.

assets I1+I2

potential private benefit B(I1 + I2)

income in case of success R(I1 + I2)


Slide33 l.jpg

As usual

and

Lender i and entrepreneur i sign (secret) loan agreement {Ii , Rbi},


Slide35 l.jpg

LIQUIDATION VALUES

Both firms in distress: no revenue for anyone.

None in distress: standard model.

Firm 1 in distress, firm 2 is not:

Assumption: lender 1 makes take-it-or-leave-it offer to lender 2.

Lender 2 must adjust incentive scheme:

becomes


Slide36 l.jpg

Discount since 0 < 1.

Extra rent for entrepreneur 2:


Slide37 l.jpg

Entrepreneur’s expected utility:

where

and


Slide38 l.jpg

Debt capacity decreases with correlation between  shocks.

Ii = kAi where

Ii  1(minimum scale) and  < 0

multiple equilibria (complementarity).

  • Financial muscle: do potential acquirers build too much or too little financial muscle for M & As? See chapter 14.


  • Login